Markups, Gaps, and the Welfare Costs of Business Fluctuations

In this paper we present a simple, theory-based measure of the variations in aggregate economic efficiency associated with business fluctuations. We decompose this indicator, which we refer to as the gap, into two constituent parts: a price markup and a wage markup, and show that the latter accounts for the bulk of the fluctuations in our gap measure. We also demonstrate the connection between our gap measure and the gap between ouput and its natural level, a more traditional indicator of aggregate efficiency. Finally, we derive a measure of the welfare costs of business cycles that is directly related to our gap variable. When applied to postwar U.S. data, for some plausible parametrizations, our measure indicates non-negligible welfare losses of gap fluctuations.